Which housing markets are most exposed to the next interest rate storm?
Stocks are crashing, a cost of living crisis is in full swing and the specter of a global recession looms. But you wouldn’t know that by looking at wealthy country property markets, many of which continue to break records. Homes in America and Britain are selling faster than ever. Home prices in Canada have climbed 26% since the start of the pandemic. An average property in New Zealand could cost you over NZ$1 million, an increase of 46% since 2019.
For more than a decade, homeowners have enjoyed extremely low interest rates. Now, however, an interest rate storm is brewing. On May 5, the Bank of England, having forecast that inflation in Britain could exceed 10% later this year, raised its key rate for the fourth time, to 1%. The day before, the US Federal Reserve had raised its benchmark rate by half a percentage point and hinted that further tightening would follow. Investors expect the fed funds rate to top 3% by early 2023, more than triple its current level. Most other central banks in the rich world have also started to tighten monetary brakes, or are about to do so.
Many economists think a 2008-style global housing crash is unlikely. Household finances have strengthened since the financial crisis and lending standards are tighter. The scarcity of housing supply, combined with robust demand, high levels of household net worth and buoyant labor markets should also support house prices. But the rising cost of money could make it difficult to manage homeowners’ current debt load by increasing their repayments, while discouraging some potential buyers. If this impact on demand is large enough, prices could start to fall.
The vulnerability of homeowners to large increases in mortgage payments varies by country. In Australia and New Zealand, where prices jumped more than 20% last year, stocks have gotten so out of control that they are sensitive to even modest increases in interest rates. In less torrid markets, such as America and Britain, interest rates may need to approach 4% for house prices to fall, estimates Capital Economics, a consultancy. Alongside price levels, three other factors will help determine whether the housing juggernaut simply slows down or comes to a halt: the extent to which homeowners have mortgages rather than own their property; the prevalence of variable rate mortgages rather than fixed rate loans; and the amount of debt taken on by households.
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Consider first the share of mortgage holders in an economy. The fewer homeowners who own their property, the greater the impact of a rate hike is likely to be. Denmark, Norway and Sweden have some of the highest shares of mortgage holders in the world. A loosening of lending standards in response to the pandemic has boosted borrowing. In Sweden, tax breaks for landlords further fueled the rush for mortgages, while a dysfunctional rental market, characterized by overpriced (and illegal) subletting, pushed more tenants into homeownership. All of this puts Nordic banks in a tricky position. In Norway and Sweden, housing loans account for more than a third of banks’ total assets. In Denmark, they account for nearly 50% of lenders’ books. Sharp falls in real estate prices could lead to losses.
Unlike the Nordic countries, where home ownership was fueled by the growth of mortgage markets, many households in central and eastern European countries bought houses debt-free in the 1990s because real estate was so cheap. In Lithuania and Romania, more than four-fifths of households are pure and simple owners. Mortgage-free households are also higher in southern Europe, notably in Spain and Italy, where inheritance or family support is a common route to home ownership. Germans, on the other hand, are more likely to rent than own their homes. Rate increases will therefore have less direct impact on prices.
The structure of mortgage debt – the second factor – is also important. Rising interest rates will be felt almost instantly by borrowers with variable rates, which fluctuate with changes in key rates; for those with fixed rates, the pain will be delayed. In America, mortgage rates tend to be fixed for two or three decades. In Canada, almost half of home loans have fixed rates for five years or more. In contrast, loans in Finland are priced almost entirely at floating rates. In Australia, around four-fifths of mortgages are linked to variable rates.
However, just looking at the proportion of fixed versus variable rate borrowers can be misleading. In some countries, mortgage rates can often be fixed, but for too short a period to protect borrowers from the interest rate storm. In New Zealand, fixed-rate mortgages make up the bulk of existing loans, but nearly three-fifths are fixed for less than a year. In Britain, almost half of fixed rate stock is valid for up to two years.
Resistance to rising rates will also depend on the amount of debt taken on by households, our third factor. The high level of indebtedness became evident during the global financial crisis. As house prices fell, households with high mortgage repayments relative to their incomes found themselves squeezed. Today, households are richer, but many are more indebted than ever. As Canadians added US$2.8 trillion to their combined savings during the pandemic, pushing their net worth to a record US$12.2 trillion by the end of 2021, their voracious appetite for homes has driven household debt at 137% of income. The share of new mortgages with extreme loan-to-income ratios (i.e. above 4.5) has also increased, prompting Canada’s central bank to issue a warning about debt levels bred in November 2021.
Watchdogs in Europe are also worried. In February, the European Systemic Risk Board warned of unsustainable mortgage debt in Denmark, Luxembourg, the Netherlands, Norway and Sweden. In Australia, average homeowner debt as a percentage of income has ballooned to 150%. In all of these countries, households will face colossal monthly repayments even as soaring food and energy prices eat into their incomes.
Put it all together and some housing markets look set to suffer more than others. Property in America, which has borne the brunt of the fallout from the subprime lending crisis, appears better insulated than many major economies. Borrowers and lenders there have become more cautious since 2009, and fixed rates are much more popular. Housing markets in Britain and France will fare better in the short term, but look exposed if rates rise further. Real estate in Germany and in Southern and Eastern Europe appears even less vulnerable. On the other hand, prices could be more sensitive to rate hikes in Australia and New Zealand, Canada and the Nordic countries.
A floor in house prices means that in most countries demand still far outstrips supply. Strong labor markets, hordes of millennials approaching home-buying years, and a shift to remote working have increased demand for more living space. New properties remain scarce, which will support competition for homes and keep prices high. In Britain, there were 36% fewer property adverts in February than at the start of 2020; in America, there were 62% fewer registrations in March compared to the previous year. The alternative to owning a home – renting – isn’t particularly appealing either. Across Britain, average rents were 15% higher in April than at the start of 2020. In America, they rose by a fifth in 2021; in Miami, they jumped almost 50%. Potential tenants of rent-controlled properties in Stockholm face an average waiting time of nine years.
As the era of ultra-cheap money draws to a close, housing demand is not about to collapse. Yet one way or another, tenants and landlords will face increasing pressure.
© 2020 The Economist Newspaper Limited. All rights reserved. Excerpt from The Economist published under licence. The original article can be found at www.economist.com